Switzerland: Key Questions On Subordination

There are different forms and treatments of subordination agreements in Swiss insolvency. This article is inspired by the authors' experience representing the security agent of $1.75 billion bond issue of a Swiss based oil refinery group

When a group of lenders extends credit to the same borrower, it usually enters into an intercreditor agreement, a key component of which is a subordination provision setting out the ranking and priority of repayment rights. In addition, the subordination of intragroup funding, ie loan agreements between group companies, to the lenders' claims is frequently seen in financing transactions. In Switzerland, subordination agreements also serve as an instrument under company law (article 725 II Swiss Code of Obligations (CO)) that enables over-indebted companies to continue doing business. The subordination clauses as seen in the intercreditor agreements or other debt financing structures on the one hand (Nachrangigkeit) and subordination agreements satisfying the requirements of article 725 II CO (Rangrücktritt) on the other serve different purposes and need to be carefully distinguished. Although all subordination agreements are concluded with a view to a possible insolvency of the borrower, their effect and enforceability in Swiss insolvency proceedings is only clear if falling under article 725 II CO, whereas the treatment of other contractual subordination is uncertain.

Subordination pursuant to article 725 II CO

Under Swiss corporate law, the board of directors has to take specific measures if the company finds itself in distress. These measures include a duty to notify the bankruptcy court, if a company suffers from a capital deficit to the extent that the claims of the company's creditors are no longer covered, whether the assets are appraised at going concern or liquidation values (over-indebtedness). The board of directors can refrain from notifying the judge, if a creditor subordinates its claims in the amount of the capital deficit to all other liabilities pursuant to article 725 II CO. There is no need for the board of directors to obtain approval from the other creditors or the shareholders. By subordinating their claims, creditors agree that, if insolvency proceedings are opened over the borrower company, dividend distributions will only be paid out to them if and after all other unsubordinated and unsecured claims are satisfied in full.

An agreement to subordinate a claim does not constitute a waiver. The borrower company must continue to account for subordinated claims as liabilities and disclose the subordinated loan separately in the annual financial statements. Accordingly, the subordination itself does not constitute a restructuring measure since the financial situation of the company remains unchanged. However, subordination agreements increase the chances for a distressed company to financially recover as they allow for more time to adopt restructuring measures. Subordinated loans pursuant to article 725 II CO have in practice often been used as de facto equity surrogates for many years, although this is not the intention of the law. It is important to note that the Swiss Federal Supreme Court held that subordinated claims are to be included in the calculation of damage when ruling on a director's liability claim.

The law stipulates that the board of directors can only refrain from notifying the judge if the amount of subordinated claims equals or exceeds the capital deficit. The wording of article 725 II CO does not indicate whether the deficit should be appraised at going concern or liquidation values for the purposes of determining the necessary subordination amount. The question is controversially discussed. Some authors argue that in addition to the capital deficit the subordination amount should cover at least part of the share capital. A 2003 judgment of the Swiss Federal Supreme Court dealing with the termination of a subordination agreement, indicates that it is admissible to appraise assets at going concern value if the company is expected to overcome the state of overindebtedness. If this is not the case, for example due to the company's liquidity problems, accounting on a going concern basis is no longer permitted. In such a case, the extent of the subordination of claims required needs to be calculated at liquidation values, which usually makes restructuring impossible. The going concern statement of the auditors is paying an important role in the termination of the subordination and any restructurings.

Legal doctrine and case law have determined that any subordination agreement needs to include a deferral agreement, at least with regards to the principal amount of the loan, as well as a prohibition for the borrower to repay or set off the subordinated liabilities. If it were possible to satisfy the subordinated creditor before insolvency, this would jeopardise the purpose of article 725 II CO to improve the borrower's financial situation, and the position of the other unsubordinated and unsecured creditors. The declaration to subordinate must further be irrevocable, unconditional and unlimited in time (although termination is possible under the requirements explained below) to meet the requirements of article 725 II CO. Finally, the claim covered by subordination may not be collateralised with assets of the borrower.

The subordination agreement can only be terminated once the borrower company is no longer over-indebted, which may be assessed on a going concern basis. Until then, the subordination agreement remains effective, according to the Federal Supreme Court.

Subordination agreements in debt financing – relative subordination

In addition to the subordination pursuant to article 725 II CO, which constitutes a company law instrument and may enable restructuring measures, subordination agreements can serve to secure the payment of debt owed to one or more specific creditors and are most commonly used in the context of financing transactions. Since the subordination according to article 725 II CO benefits all other creditors, it is often referred to as general subordination. This is in contrast to the subordination agreements intended to benefit only specific lenders, ie provide for relative subordination. If the subordination is not intended to have the effect of article 725 II CO, it does not have to fulfil the requirements described above. In most cases though, a subordination agreement will contain a deferral as well as a prohibition of repayment or set off, to ensure the intended effect of the subordination. In addition, the subordinated creditor might assign its claim to the senior creditor. However, such assignment of the subordinated claim is not mandatory to give effect to the relative subordination.

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